Accounting 2

Access Weekend

Course Intro

Managerial accounting is the process of identifying, analyzing, and communicating information in pursuit of an organization’s goals.

Managerial Accounting focuses on the process of identifying and measuring the benefits and costs of an organization’s decision options to support two types of decisions:

• Planning Decisions: choices about acquiring and using resources to deliver products and services to customers

• Control Decisions: choices about how to motivate, monitor, and evaluate the performance of employees in order to align their goals with those of the organization.

A Framework for Decision-Making

1. Specify the decision problem, including the decision maker’s objective.
2. Identify the options.
3. Measure the costs and benefits
4. Choose the alternative with the highest value.

Intro to Financial Statement Analysis

KEY CONCEPTS

• How to interpret financial statements
• How to interpret various ratios and how different transactions and/or decisions will affect the ratios.
• Understand what we learn by computing and comparing different ratios and how those comparisons can inform us about the firm.
• Understand how to drill down from high-level ROE calculations to specific factors and provide tentative recommendations about how to improve.

Balance Sheet

\[ Asset = Liability + Equity \]

Common balance sheet only transactions:

• Receive cash from investors (debt or quity holder)
• Trade an asset for another asset
• Buy an asset and pay cash
• Buy an asset and incur a liability to be paid later
• Pay cash to reduce a liability

Income Statement

\[ Net\,Income = Total\,Revenue - Total\,Expenses \]

Recognize revenues or expense when they are earned or incurred, not necessarily when the cash enters or leaves the firm's coffers.

Statement of Cash Flows

Burn rate - the rate at which a startup spends its cash per month

Indirect Method

Financial Statement Articulation

Common Size Financial Statement

A common size income statement expresses all income statemenr items as a percentage of sales. A common size balance sheet expresses all balace sheet items as a percentage of total assets.

DuPont Analysis of Return on Equity (ROE)

\[ROE=\frac{Net\,Income}{Stockholder's\,Equity}=\frac{Net Income}{Sales}*\frac{Sales}{Assets}*\frac{Assets}{Stockholder's\,Equity}\]

ROE is the product of profit margin, asset turnover, and the equity multiplier.

\[ROA=\frac{Net\,Income}{Total Assets}\]

Profitability Ratios

Profitability ratios measure the ability of a firm’s revenues to cover its costs.

\[Gross\,Margin=\frac{Gross\,Profit}{Sales}\]

\[Operating\,Margin=\frac{Operating\,Income}{Sales}\]

\[Net\,Margin=\frac{Net\,Income}{Sales}\]

Gross Profit - less COGS

Operating Profit - less COGS, Fixed Cost, Vairable Expenses, Amortization, and Depreciation

Operating Profit - less COGS, Fixed Cost, Vairable Expenses, Amortization, Depreciation, Interest, and Tax (EBIT - Earning Before Interest and Tax)

EBIT - Earning Before Interest and Tax (Operating Profit)

EBITA - Earning Before Interest, Tax, and Amortization

EBITDA - Earning Before Interest, Tax, Depreciation and Amortization (lower than gross profit)

Asset Efficiency Ratios

Asset efficiency ratios measure the dollars of sales generated by each dollar invested in assets.

\[Turn\,Asset\,Turnover=\frac{Sales}{Total\,Assets}\]

\[Fixed\,Asset\,Turnover=\frac{Sales}{Net\,Fixed\,Assets}\]

\[Accounts\,Receivable\,Turnover=\frac{Sales}{Accounts\,Receivable}\]

\[Days\,Sales\,in\,AR=\frac{Accounts\,Receivable}{Sales\,per\,Day}\]

how long it takes the customer to pay us on average

\[Inventory\,Turnover=\frac{COGS}{Inventory}\]

\[Days\,in\,Inventory=\frac{Inventory}{COGS\,Per\,Day}\]

how long it takes from acquisition to sell

Debt Management Ratios

Debt management ratios measure the degree of financial leverage or overall indebtedness of the firm.

\[Long-term\,Debt\,to\,Total\,Assets=\frac{Long-term\,Debt}{Total\,Assets}\]

\[Equity\,Multiplier=\frac{Total\,Assets}{Shakeholder's\,Equity}\]

Liquidity Metrics

Liquidity metrics reflect a company’s ability to pay debt obligations and its margin of safety. (Bankruptcy Analysts)

\[Working\,Capital(WC)=Current\,Assets-Current\,Liabilities\]

Money that will be avilable for a dividend

\[Current\,Ratio(CR)=\frac{Current\,Assets}{Current\,Liabilities}\]

\[Quick\,Ratio(QR)=\frac{Cash+Short-term\,Investments}{Current\,Liabilities}\]

Anassessment of whether there is enough liquidity to pay the bills

Accounting Tools for Decision Making

KEY CONCEPTS

• Know how to assess the impact of various decisions on short-term profit.
• Be able to use accounting information to identify and/or compute the opportunity cost of a decision option in different situations. Be able to identify what costs or revenues are relevant in different situations.
• Understand how to use the basic cost-volume-profit model to compute various figures such as break-even quantity, target quantity, target price, indifference probability, etc.
• Understand how to expand the basic cost-volume-profit model to allow for multiple products and/or multiple types of variable costs.
• Understand how to estimate fixed and variable costs using the high-low method.
• Understand how to estimate fixed and variable costs by using the context of the decision to classify different costs as fixed or variable.
• Know how to prioritize production (or make product mix decisions) in the presence of a production constraint.

Differential Analysis

CVP Model (cost-volume-profit model)

\[Total\,Contribution\,Margin = Total\,Revenue - Total\,Variable\,Cost\]

\[Unit\,Contribution\,Margin = Selling\,Price - Unit\,Variable\,Cost\]

\[π=(P-UVC)Q-FC\]

WUCM: weighted average unit contribution margin

Cost Classification:

• Product Costs: Costs associated with getting products and services ready for sale. They are expensed as “cost of goods sold” when the product is sold.
• Period Costs: Costs not directly associated with readying products and services ready for sale. Not included in “cost of goods sold”. Instead, they are expensed below the gross margin line at the end of the reporting period in which they are incurred.

Cost Variability:

• Variable Cost: A cost that varies with the level of activity.
• Fixed Cost: A cost that does not vary with the level of activity.
• Mixed Cost: A cost that contains both fixed and variable components.
• Step Cost: A cost that increases in discrete amounts as the volume of activity increases. That is, the cost is fixed for a given range of activity but, if activity is increased beyond that range, the cost increases a lump sum amount and stays fixed again for another range of activity, and so on.

Cost Hierarchy:

• Unit-level Cost: A cost that increases or decreases in direct proportion to the number of units produced.
• Batch-level Cost: A cost that varies in proportion to the number of batches of units made.
• Product-level Cost: A cost that varies in proportion to the number of products a firm produces.
• Facility-level Cost: A cost that does not vary at the unit, batch or product level.

Cost Relevance:

• Relevant Cost (and benefits): A cost (or benefit) that changes across different decision options.
• Sunk Cost: An expenditure incurred in the past that cannot be reversed.
• Opportunity Cost: The opportunity cost of a decision option is the value to the decision maker of the best alternative option.

Short-term Decision

A short-term decision is characterized by two aspects:

1. a short horizon (it only affects the profits of this period or, for some reason, we are only interested in this period);
2. the firm cannot change capacity in the short horizon.

Important Implications of Capacity Constraints:

1. The goal of maximizing Total Profits can be simplified to maximizing Total Contribution Margin (which we define as Total Revenues - Total Variable Costs).
2. A firm considering a short-term decision will be faced with one of two possible scenarios: (a) excess capacity or (b) excess demand.

Potential Short-term Solutions to Excess Capacity:

• Reduce price
• Accumulate inventory
• Produce inputs in house
• More aggressive marketing

Potential Short-term Solutions to Excess Demand: * Increase price * Alter product mix (find the product mix that maximizes total contribution subject to the capacity constraint) * Outsource * Scale back marketing

Relevant Costs in the Presence of Capacity Constraints:

While maximizing total contribution is always the objective, the key difference when analyzing decisions with excess capacity versus excess demand is that way we think about relevant costs.

• The relevant cost in the presence of excess capacity is simply the variable cost of production.
• The relevant cost in the presence of excess demand is the contribution we give up by choosing one option over another.
• We can identify this opportunity cost by computing throughput for each decision option.

Throughput = Contribution / Units of Constraint

Pricing Simulation

• Managers must combine different types of information when making decisions in a competitive environment
• Costs are relevant for optimal pricing. Understnding which cost are relevant and why help managers navigate competitive envionmrnts were effectively. We should understand our own costs as well as competitors.

Cost Allocations and Activity-based Costing

KEY CONCEPTS

• Understand how to estimate long-run costs and assess long-run profitability using a traditional costing system.
• Understand how to estimate long-run costs and assess long-run profitability using an activity-based costing system
• Understand what causes the differences in estimates provided by the traditional versus activity-based systems.
• Understand what conditions cause a firm to benefit most from installing an activity-based costing system.
• Understand the distinction between a short- and long-run decision and how to assess the short-run implications of long-run decisions.

• Understand how to apply activity-based costing techniques to evaluate the long-term profitability of various cost objects

• Cost Allocation is the process of identifying, aggregating, and assigning costs to cost objects.

• A Cost Object is any item for which we want to separately measure costs. Products, product lines, production lines, services, organization departments, and customers are all examples of cost objects.
• Direct Costs for a given cost object are costs that have a direct cause-and-effect relationship with the cost object. The defining characteristic of a direct cost is that the cost would not exist absent the cost object. Direct costs are, by definition, variable costs.
• Indirect Costs are not directly caused by the cost object. Indirect costs may be either variable or fixed. Indirect costs are also often referred to as ‘production overhead,’ ‘manufacturing overhead,’ or simply ‘overhead’.
• Capacity Costs are fixed expenses incurred by an organization to provide for its ability to conduct business operations. Capacity costs generally do not vary with production levels and can be reduced or avoided only by shutting down business locations or outsourcing.

Additional Key Terms:

• A Cost Pool is a temporary account that is used to collect and total indirect costs incurred during the production process
• A Cost Driver is a unit of an activity that represents an organization’s resources being used or consumed.
• The Cost Driver Rate, Allocation Rate, or Burden Rate is the amount of indirect cost assigned to each unit of cost driver activity.

Steps of Cost Allocation:

1. Identify cost objects
2. Determine the relevant costs
3. Assign direct costs directly to the appropriate cost objects
4. Distribute relevant indirect costs (variable overhead and common fixed costs) among cost pools
5. Choose a cost driver for each cost pool
6. Calculate the cost driver rate for each cost pool
7. Allocate the indirect costs to cost objects based on the consumption of the cost driver

Major Applications of Cost Allocations: * Financial Reporting (GAAP) * Cost Justification (e.g. Government contracts, research grants, etc.) * Incentives and Performance Evaluation * Long-term decision making

Variable Costing vs. Absorption Costing

Long-term Decision Making:

• Expand capacity
• Entering new markets
• Adding or dropping a new product
• Mergers and acquisitions
• Pricing policy

Methods of estimating the cost of capacity resources when making decisions:

1. Direct Estimation: systematically examining each cost account to evaluate whether (and how much) a decision would change a capacity cost.
2. Allocations: estimate the cost of a decision option by distributing common fixed costs according to a pre-determined rule.

Cost Allocation Flaw:

1. In allocating the manufacturing overhead using a single cost driver, the cost system assumes that different products consume the firm’s resources homogeneously. This assumption likely does not hold in this situation.
2. The system allocates the cost of unused capacity to the products. This is causing a downward demand spiral or “Death Spiral”: (a) Products that look unprofitable are dropped (b) Variable costs are eliminated jointly with the revenue (the contribution margin of those products is gone). However, the manufacturing overhead is not necessarily avoided in the same proportion at the time the product is dropped. (c) Dropping a seemingly unprofitable product, consequently, may lead to an increase in unused capacity resources . The traditional costing system reallocates the cost of these unused resources to the remaining products and reduces their reported profitability. (d) The cycle starts again with the elimination of other “unprofitable” products.

3. The information does not allow management to distinguish between the shortterm and long-term effects of a decision. The immediate effect of dropping a product is a reduction in the contribution margin. So, unless the immediately avoidable fixed costs surpass the lost contribution margin, dropping the product will reduce short-run profit for the firm. Although the profitability in the long run should be calculated using the allocation of capacity resources, a decision maker should also understand the short-term consequences of the decisions.

4. We must take care to only include the amount of the fixed asset’s capacity the cost object has used.

5. Dropping a product is considered a long-term decision, but dropping a product can have dramatic shot-term effects on profitability that should be considered carefully. – Many capacity costs are not controllable in the short-run. These capacity costs will not be avoided (immediately in the short-run) if a product is dropped. The contribution margin associated with these products, however, will be lost immediately. – The timing of a product drop should be managed such that it coincides with the expiration of the relevant long-term obligations (i.e. contracts, asset ownership, etc.).
6. Non-controllable costs associated with eliminated products should not be reallocated to remaining products. They should be treated as period costs (unused capacity costs).
7. Allocating overhead costs based on a single driver implicitly assumes products consume overhead resources homogeneously. This assumption leads to distorted cost estimates.

The "Death Spiral"

Activity Based Costing and Management

• Step 1 - Forming Cost Pools (classify activities: unit level, batch level, product level, facility level)
• Step 2 - Deciding which costs to allocate
• Step 3 - Identifying cost drivers (easily measured, a strong causal relationship)
• Step 4 - Measuring denominator volume (practical capacity)

Budgeting and Variance Analysis

KEY CONCEPTS

• Understand how to compute and interpret each of the variances
  • Total profit variance
  • Sales volume variance for profits / Flex budget variance for profits
  • Sales volume variance for revenues / Flex budget variance for revenues (sales price variance)
  • Sales volume variance for variable costs / Flex budget variance for variable costs
    • Break down the flex budget variance: Quantity Variance (efficiency variance) / Price Variance (spending variance or input price variance))
  • Fixed cost variance
• Understand how different variances could be related.

Variance Analysis is a technique firms use to determine why actual revenues, costs, and profit differ from their budgeted amounts.

• determine whether employees and processes are performing as expected.
• motivate employees and improve future planning decisions.

Business Unit Performance Evaluation

KEY CONCEPTS

• Know how to compute net present value of cashflows to evaluate whether a potential investment is in the best interest of the firm
• Know how to compute Return on Investment and Residual Income using the basic formulas we discussed in class
• Understand when the use of Return on Investment or Residual Income as a performance measure is goal congruent and when it is not

ROI

\[ROI(t)=\frac{Profit(t)}{Investment(t-1)}\]

Why does ROI performance measure lead to congruence decision? Since total ROI is a weighted average of the individual project ROIs, taking on any project with a higher ROI than the status quo ROI will result in a higher total ROI.

Residual Income

\[RI(t)=Profit(t) - Cost\,of\,Capital * Investment(t-1)\]

Decentralization

As firms grow and become more complex, decentralization becomes a necessary part of running the business. A downside of decentralization is that it delegates decision making authority to managers that have local (or personal) objectives that may differ from those of the firm more broadly.

Performance Evaluation and Incentives

Firms use accounting-based performance measures (and incentive contracts) to manage the costs associated with decentralization. The goal of a performance evaluation system is to bring a manager’s personal objectives in line with those of the firm.

Weakness of Performance Measures

Return on Investment (ROI) is an intuitive and commonly used performance measure. The fact that ROI is a weighted average of performance leads managers to either over or under invest in new projects depending on their past performance.

Residual Income (RI) overcomes the under/over investment problem of ROI but does not completely solve all incentive problems (i.e., the horizon problem). In addition, RI is not as intuitive as ROI.

Adjustments to the way operating income and investment center performance is measured can further reduce incentive problems. Economic Value Added (EVA) is an example of a system that attempts to make such adjustments. The disadvantage of using numerous adjustments is that they can be difficult to understand and require frequent recalculations (depending on the project or asset).

Transfer Pricing

KEY CONCEPTS

• Understand how different transfer pricing policies (cost-based transfer prices, market-based transfer prices, or negotiated transfer prices) affect the incentives of divisional managers in a firm
• Identify the minimum transfer price the upstream division would be willing to accept
• Identify the maximum transfer price the downstream division would be willing to pay
• Know how to evaluate whether a specific transfer pricing policy is goal congruent or not

A transfer prices is the price a firm uses to account for transfers of goods or services between two or more divisions (or responsibility centers) in a firm. The transfer price is recorded as a revenue for the upstream division and as a cost for the downstream division. (do not show up in the calculation of total, firm-wide profits)

Transfer prices matter because they affect the incentives and decision-making of divisional managers.

Difficulty:

• Expecting top management to set transfer prices that work well in every situation is not practicable.
• The inherent conflict of interest between divisional managers.

Common Approaches to Transfer Pricing:

• Cost-based transfer prices (including variable and full cost)
  • Cost-based transfer prices are determined by adding a markup to either the variable or full production cost of the transferred good or service.
  • Variable cost-based transfer prices are most appropriate for a short-term problem in which a selling division has excess capacity.
  • Full cost-based transfer prices are useful in the context of long-term planning and decision making.
• Market-based transfer prices
  • Market-based transfer prices set the price at the competitive market price. This transfer pricing method is appealing because the market price is a useful measure of the opportunity cost of interdivisional transfer. Using market-based transfer pricing often results in both divisions voluntarily making the right decisions (from the perspective of the firm). Market based transfer pricing is impossible in some settings because there is no market for the transferred goods or services.
• Negotiated transfer prices
  • Negotiated transfer prices are determined by negotiations between the two divisions. This provides the divisions with complete autonomy and will lead to effective decisions (as long as divisional mangers behave rationally). Negotiations often break down, however, because they are time consuming and highlight the conflicting interests of the divisional managers.

Analyzing Transfer Pricing Policies:

• Firm’s Perspective
  • Head office's objective is to maximize firm-wide operating profits
  • which approach to use
• Upstream Division Manager’s Perspective
  • Maximize the upstream division's operating profits
  • The decision options for the upstream division include selling a good or service to outside customers, selling to internal customers (or other divisions inside the firm), or not selling anything at all.
• Downstream Division Manager’s Perspective
  • Maximize the downstream division's operating profits
  • The decision options for the downstream division include purchasing a good or service from outside suppliers, purchasing from an internal supplier (or another division inside the firm), or not purchasing anything at all.

Why is transfer price not equal to opportunity cost?

Decentralizing, we don't know what it should be, opportunity cost changes based on how close to capaciy we are

Transfer Pricing Policy Methods: